VMware (NYSE:VMW) is a very profitable and cheap cloud stock that has taken a dip worth buying. The company just reported its annual fiscal earnings ending Jan. 31. It shows that VMware makes huge margins in its cloud software subscription, licensing and serving business.
However, the company, 80.7% owned by Dell (NYSE:DELL), which also controls 97.5% of its voting power, is facing competitive issues.
VMware Stock Has Issues
Barron’s recently published an interesting report on VMware’s competition from a technology called Kubernetes.
The gist of the article is that more companies are migrating their data and operations to the cloud faster than ever. This is bad news for much of VMWare’s legacy software, other than its recent acquisition of Pivotal, a cloud company.
VMware stock took a hit on Friday, Feb. 28, since the “company’s uncertain commentary over its core on-premise server software business may have spooked investors the most.”
In other words, the shift to the cloud is moving faster and VMware may be losing business. At least that is what the market is worried about.
VMWare Is Doing Quite Nicely, Thank You
The company gave a forecast for its revenue and cash flow, which although below analysts’ expectations, still is extremely profitable. Barron’s reported about the market’s disappointment with the numbers and VMware’s apparent shortfall.
For example, the company reported Q4 adjusted earnings per share of $2.05 versus the Wall Street consensus estimate of $2.17, according to FactSet.
However, not everything was so bad. VMware posted revenue of $3.07 billion for the same quarter, up 11% year over year. But this was above the $2.95 billion average analyst estimate.
But let’s keep things in perspective. Free cash flow for the fourth quarter was $1.02 billion. This is a huge margin compared to its revenue. Free cash flow represented one-third of its quarterly revenue. That is huge.
Moreover, free cash flow margins for the year ending Jan. 31 was even higher. VMware generated $3.59 billion in free cash flow. This represents a margin of 35.8% on its annual revenue of $10.81 billion.
Very few businesses can convert this much of its revenue into free cash flow. Moreover, the forward outlook is not all that bad.
The Outlook Is Not as Bleak as Some Say
The truth is VMware is going to be generating good profits for a good while, even if the cloud migration proceeds faster than its legacy revenue fades.
For example, the company projected that its coming fiscal year should result in $3.76 billion in free cash flow. That still represents a margin of 31% on its expected revenue of $12.05 billion this year. And that revenue will be up at least 11%, according to the company.
How can the company be so sure about its outlook? One reason is the huge amount of “unearned” revenue it has in its backlog.
For example, VMware reported that it had $9.268 billion in unearned revenue. Companies used to call this “deferred’ revenue. In addition, it has $4.05 billion in long-term unearned revenue.
This $13.3 billion in total unearned revenue represents contracts that its clients have signed but the revenue has not yet been earned or billed. In effect, it is a hidden asset.
Yes, lots of software companies have these assets. Sometimes companies can switch out of these contracts. But VMware’s purchases of Pivotal and Carbon Black, which both operate in the cloud migration space, will help the company keep these clients.
What Analysts Are Saying About VMware Stock
Barron’s reported that Jefferies analyst Brent Thill reiterated his “buy” rating for VMware stock on Friday, Feb. 28. This implication was that this was a sort of tepid promotion of VMware stock.
Deutsche Bank cut its price target to $165 from $190 after the earnings. Right now VMware stock is at $120.52, so this represents upside of just 37%, instead of 58%. But the point is the analyst thinks the stock is worth a good deal less now.
By the way, if they are correct, this is not good news for Dell stock, since it represents a huge portion of its total value. Seeking Alpha analyst Thomas Lott published an interesting article in December about VMWare as part of its sum-of-the-parts valuation.
What Should Investors Do With VMware Stock?
Right now VMware stock trades with an implied free cash flow yield of 7.5%. That is derived by taking the expected $3.76 billion in free cash flow this year divided by its $50 billion market value today.
Other tech stocks like ServiceNow (NYSE:NOW) are much more expensive. Its FCF yield is 1.6%. Another competitor Arista Networks (NYSE:ANET) has a more expensive 6.4% FCF yield on a last 12 months (LTM) basis.
So the bottom line is that VMware stock is cheap, but not as much as some of its peers. Given analysts’ disappointment with the stock with its latest results, it is possible WMware stock might fall further.
However, investors should keep in mind that this is still a very profitable $50 billion market value company. It produces a large amount of free cash flow each year. Moreover, it has a large inventory of unearned revenue. It is not going to fade away, despite what some authors and analysts might lead you to believe.
As of this writing, Mark Hake, CFA does not hold a position in any of the aforementioned securities. Mark Hake runs the Total Yield Value Guide which you can review here. The Guide focuses on high total yield value stocks. Subscribers get a two-week free trial.